Morgan Stanley Investment Management Finds Value in Emerging Europe

Morgan Stanley Investment Management is betting that stocks in Eastern Europe are going to do better amid the selloff in emerging markets, said the firm’s Ruchir Sharma.

Stocks, bonds and currencies of developing nations have taken a beating since late May, when Federal Reserve Chairman Ben Bernanke signaled that the U.S. central bank could scale back its bond-buying stimulus program later this year. The MSCI Emerging Market index, which tracks equity markets of developing countries, is down 11.7% this year and 1.6% in August amid the latest wave of selling.

But in the midst of the market anxiety, investors may be missing “pockets of value” in countries that have their financial houses in order, said Mr. Sharma, head of emerging markets and global macro at Morgan Stanley Investment Management and author of “Breakout Nations: In Pursuit of the Next Economic Miracles.”

Since the massive market rout for emerging markets in May and June, Mr. Sharma’s firm has added to holdings of stocks in Poland, Romania and the Czech Republic, three countries that have largely escaped the turmoil that has overtaken emerging markets in recent weeks. Poland’s stock market is up 4.7% in August, Romania’s has gained around 9% and the Czech Republic is up 4.2%. The Czech Republic’s stock market is still in negative territory for the year, however, amid broad-based selling of emerging markets.

Even before the latest emerging-market rout, these Central and Eastern European markets had been dragged down heavily because of the euro-zone debt crisis, as many of these countries’ economies are exposed to Western Europe, he said. The MSCI Emerging Market Europe index recently traded at 423.421, which is still 32% lower than its 2011 peak.

“Now we’re seeing some signs of stability in Western Europe,” Mr. Sharma said. Economies like Poland and the Czech Republic will likely be among the biggest beneficiaries of a recovery in the euro zone, analysts say.

In addition, Mr. Sharma said Poland was becoming more attractive as its current-account deficit narrows, and said the country’s central bank has sufficient policy room to cut interest rates.

In Asia, he’s holding on to stocks from Thailand and the Philippines amid the turmoil in emerging markets.

Investors “may have been harsh on” Thailand when they sent shares down 9.6% so far this year, Mr. Sharma said. The country’s policy makers are working to reform the economy and its current-account gap is not as large as some of its emerging-market peers, such as India.

The Philippines, meanwhile, could grow by as much as 7% this year, which would make it one of the fastest growing economies in the world, he said.

Morgan Stanley, however, has reduced its holdings of Indonesia since the beginning of the year, and its wide current-account deficit is a concern for Mr. Sharma. Indonesia’s central bank said last week that the nation’s current-account deficit had widened to $9.8 billion during the second quarter of the year, from $5.8 billion in the previous quarter.

For other countries with large current-account gaps, such as India, Brazil and Turkey, the firm has largely been “standing on the sidelines,” Mr. Sharma said. The firm remains neutral on India and bearish on Brazil and South Africa, which also imports more than it exports. Both Brazil and South Africa are vulnerable to the slowing demand for commodities along with China’s “structured shift to a much lower growth rate,” he added.

In the future, Mr. Sharma said he expects investors will have to examine the growth outlooks and the fiscal and monetary policies of specific emerging-markets countries, instead of blindly investing in the asset class as many had done in the past decade, when the loose monetary policies of central banks in developed markets triggered a hunt for yield.

“What emerging markets are facing now is a fundamental reset,” he said. “There are pockets of emerging markets that will do very well, but I feel that the game has to be about picking the right country.”